As of 2020, according to the data from World Bank, there were a total of 4266 publicly traded companies in the United States and a whopping 58,200 stocks that are listed globally. My goal as an active investor in public markets is to identify a small subset of these to put money to work.

Before I get into the process of my approach to stock selection, let me spend some time discussing the alternative, owning the entire market through investing in index funds. This approach to investing, called passive investing, is backed by the sound mathematical theory of  “Efficient Market Hypothesis” (although, I have reservations underlying the assumptions that go into the development of this theory) and is the easiest way to produce market-average returns with minimal cost. The vanguard (pun intended) of this strategy is Vanguard, which offers several low-cost ETF and index funds to buy into the markets.

VTI, Vanguard Total Stock Market ETF is an example of a vehicle that can be purchased with an extremely low expense ratio of 0.03 %. VTI holds over 3900 publicly traded US stocks, which is over 90 % of all publicly traded US stocks.  The ETF is market-weighted, meaning, the percent allocation of a given stock in the fund is a function of the market cap of the underlying security. As such, to no one’s surprise, for the longest time, the ETFs top sector has been technology and as of the start of the year 2022, ~27 % of the VTI portfolio belonged to the technology sector.  It is no surprise that in 2022, VTI has underperformed its long-term averages. The ETF is down -22.35 %, as of this writing.

The upside of following a passive index investing strategy is blindly obvious: the path of least resistance approach to producing average market performance, which stands at ~9.0 % annualized in nominal terms and ~6.8 % in real terms with dividends reinvested.  Simple back-of-envelope calculations show, at a 9 % annualized growth rate, $1 invested in markets should on average grow to $6 in 20 years.

For an average investor to produce these returns, they need 100 % of their portfolio to remain invested in a broader market index, 100 % of the dividends must be reinvested and they must have the ability to stomach an upwards of a 50 percent market drawdown from time to time, notwithstanding inflation will kill into these returns, resulting in $1 growing to merely $3.7 at best, in 20 years. Not the kind of returns that will make you stand up and notice! But again, that is the point, when invested in market averages, the outcome at best will be market average and as we can see above, that also is a tall order for an average investor to expect in a lifetime of investing.

Suffice, it to say, I want more and I believe taking appropriate advantage of informational, analytical, and most significantly behavioral edge, as a small-scale non-institutional investor, it is possible to produce a long-term sustainable returns to handily beat market averages.

Returning back to the topic of stock selection, an important question that comes up is, if not the entire market, what is an appropriate number of stocks to invest in? While, answering this question will be a topic for an entire blog post, delving into portfolio construction framework, I expect to have a meaningful concentration (up to 10 % of portfolio assets) in no more than 5 stocks at any given point in time. The universe of stocks that I will be looking at in my search for these will be limited to publicly traded US-listed stocks and international stocks, that are available to US investors through ADRs.

Even with limiting myself to the universe of US public companies and US-listed ADRs, there are over 4600 stocks to scan through in search of the 5 that I want to own, truly an exercise in searching for a needle in a haystack.

One final note on why 5 and why 10 %? Simple answer, survival! I want to increase my odds of survival. Even after going through a careful exercise of the stock selection checklist, which I will get to soon, there is a very strong likelihood that I will be wrong on at least a third of my high-conviction ideas. At 5, I feel, I can achieve sufficient diversification in assets owned and with 10 % peak allocation, I leave room to take a beating and still be on two feets the next day to fight on!

Finally, getting into the process of selecting 5 stocks from the universe of >4,600 stocks! Charlie Munger’s life mantra of inversion is a handy mental model that I have cloned to reduce this impossible task to a manageable task. Rather than asking for which stocks I should own, I have inverted the process of stock selection to asking which stocks I do not want to own.

Here’s my short list of the world that I will never venture into in my search for the top 5 to own.

• Stocks with <300 Million Market Cap; i.e. no micro caps
• Stocks with less than 10 years of publicly trading history
• Negative or zero free cash flow
• Biotech
• Airlines
• Semiconductor
• Commodity

The first 2 items in the list above relate to information disadvantages. Most firms that trade in the micro-cap world are traded on the OTC market, are either very early in their life-cycle as a public company, are a one-trick pony, or are operating in a constrained addressable market environment.  Stocks with less than 10 years of public trading history have not gone through a market cycle and it is just impossible to gauge how these firms may perform in unfavorable market environments.

I am in the business of owning businesses that make money. At the end of the day, after all the expenses are taken into account, I like for firms to have some funds remaining that they can choose to deploy as they see fit. Sound capital allocation and allocators make a huge difference to a given firm’s success or failure in the long term, yet another topic for discussion that I will get to in one of my future posts. For now, suffice to say, no cash available to allocate means no capital allocation, forget sound capital allocation, and no path to long-term sustainable growth.

Finally, the last 4 items on the list belong to sectors that I feel are either in a too-hard pile or are highly influenced by market cycles. For example, for me, biotech and semiconductors belong to the too-hard pile. I have been fairly burned by investments in airlines, a sector that looks rosy but is quite limited from a growth perspective has high fixed costs, has to deal with unions and competition is fierce.  Commodity stocks are usually cyclical and unless one finds an opportunity to invest at the right time in the market cycle, it is very difficult, in my view, to make money in commodity stocks over a period of the entire market cycle. Given, one of my investment philosophies is to eschew market timing, commodity stock investment is out of scope for me.

In my next article on this topic, I will focus on qualitative metrics that I want to look for when considering an investment opportunity.